The Looming Student Loan Crisis

Failure to scrutinize employment income contributed to the housing crisis and now threatens student loans, which total more than $1 trillion.

As the class of 2013 graduates, massive student-loan defaults loom. Too many loans were given to students without considering their prospects for finding jobs after graduating and being able to repay their debts.

Why are many college graduates unable to find positions that enable them to pay off their student loans? Is it simply a sluggish economy that is not generating enough jobs? The official unemployment rate for people in their late teens and post-college years is around 16 percent — twice the national average — but factor in those who have taken lesser jobs than they expected or who have given up looking for work and that figure rises past 25 percent. As Wall Street Journal columnist Daniel Henninger summed up satirically with a fictitious self-introduction of a waiter in a posh restaurant, “Hi, I’m Marty and I’ll be your waiter for the next 40 years.”

But besides the vicissitudes of the labor market, an additional factor contributes to the poor employment prospects of many college graduates. Too many have enrolled in college believing they could have four years of fun and graduate from any four-year college after majoring in any field — gender studies, sociology, ethnic studies — and obtain well-paying jobs easily. Unfortunately for them, the market for college graduates has changed. Offering a partial remedy, Senator Wyden, a Democrat from Oregon, and Senator Rubio, a Republican from Florida, have introduced legislation requiring colleges to report the salaries of their graduates who obtain jobs, and this would go some way toward a remedy.

Except for graduates of pre-professional curricula like engineering or pharmacy, employers can afford to be choosey, even for entry-level jobs and internships. Young, inexperienced graduates who majored in liberal arts fields are finding prospective employers are looking for graduates who have taken difficult courses, have internships on their resumes, and have gotten top grades. As a result, some college graduates find jobs quickly and others drift for months and even years, unemployed or employed in jobs that do not require a college education, earning so little that they are compelled to move back with their parents and extend their adolescence. In short, too many students enroll in college without realizing that they must actually learn something from the experience; a diploma is not enough. Recruiters are sophisticated enough to distinguish graduates who majored in fun from graduates who took education seriously and had the ability to profit from diligent study.

Too many students enroll in college without realizing that they must actually learn something from the experience; a diploma is not enough.

Failure to carefully scrutinize employment income was one factor that led to the housing bubble. The student-loan program began in 1965, too early for the lessons of the recent mortgage crisis to give forewarning. But now we know. Before making such a large student loan, an applicant’s prospects in the job market should be given consideration. Failing to do so invites a high default rate on student loans. The loans are made either by the Department of Education directly or by private financial institutions and guaranteed by the U.S. Treasury. The size of this loan portfolio now exceeds the total credit-card debt of the American population.

Defaults not only increase the national debt and thereby the overall tax burden, they are also particularly damaging to the prospects of students from low-income families, who are more likely to default than students from more affluent backgrounds. Defaulting on their loans makes it more difficult for them to get on the escalator leading to a better life through improved employment opportunities — precisely what the loans were intended to accomplish.

The Consequences: Prolonged Adolescence and Bad Credit

The portfolio of federally guaranteed student loans passed the $1 trillion mark in early 2012, and it continues to grow. The portfolio consists not only of loans for students from low-income families currently in college but also of hundreds of millions of dollars worth of loans taken out by students who graduated from college decades ago or quit before graduating without fully repaying their loans.

Until quite recently, about a third of college graduates didn’t have any loan indebtedness when they graduated. Some were lucky enough to have had parents or other relatives who financed their higher educations; others went to low-cost community colleges for their first two years before transferring to senior colleges, worked at low-paying jobs, and saved for college expenses. But the proportion of graduating seniors with student-loan debt has been increasing as the cost of college keeps rising. The average four-year college graduate who took out a loan owed $26,600 in 2011, and this does not count college dropouts who incur burdensome debts before giving up. The average unpaid student loan was $23,650 for 2008 graduates and $18,650 for 2004 graduates.

Failure to carefully scrutinize employment income was one factor that led to the housing bubble.

One effect of sizeable student loans on graduates is to make it necessary to find a good job quickly. If graduates fail to find good jobs, they are trapped in a prolonged adolescent limbo, burdening their parents economically and delaying the responsibilities of marriage and children. Former students will eventually default on a considerable portion of these loans — a reasonable estimate is 40 percent — or die before paying them off. This means that student debt is likely to be a permanent drain on taxpayers, as defaults add to the ballooning federal debt.

Defaulters suffer too, as their credit standings will be ruined for years. Even some graduates of professional schools discover that they cannot find jobs in the professions they borrowed large amounts of money to train for — and cannot repay their loans. Nine graduates of New York Law School accused their alma mater of misleading them about their postgraduate employment prospects and sued.

Causes of the Student Loan Crisis

Student loans are risky because of two aspects of a trillion-dollar misunderstanding:

1. The failure of many students to understand the difference between grants, such as Pell grants, which are taxpayer gifts awarded to college students who can demonstrate financial need, and loans, which must eventually be repaid — with interest. Contributing to this misunderstanding is that both types of federal financial aid are funneled though campus departments usually called the “Office of Financial Aid.” These offices assemble for students a financial “package” covering current college expenses, including parental contributions, student earnings, grants, and loans. The time when repayment of the loans must begin — six months after graduation — is for many students in the almost unimaginable future. Many students don’t consider that the burden of large student loans can be justified only if they have a realistic chance of high future earnings from employment.

2. The assumption of most parents and politicians is that higher education is an investment in future careers. Many students regard a college education that way also, but for a large number of them, college is not investment but consumption: four fun-filled years before they have to settle down to a life of adult drudgery. That is why many enroll in courses they hear are easy, fail to do the required reading, and come late to class and leave early when they attend the class at all. For such students, college is a time-out, or in the words of psychiatrist Erik Erikson, a “psychosocial moratorium.” Do students, parents, and lawmakers really want students to incur burdensome loans that must be repaid later — or defaulted on — to finance a psychosocial moratorium?

It is not possible to predict precisely which students are likely to repay their loans and how quickly they can do it. But ignoring the likelihood of students being unable to repay their loans invites similar problems to those that contributed to the housing crisis — bankers did not require applicants for mortgage loans to make down payments, have good credit histories, or produce evidence of earnings from employment. Yet the history of banking over many centuries — and the profitability of most banks — attests to the ability of loan officers to distinguish good risks from bad ones.

Too many loans were given to students without paying attention to their prospects for finding jobs after graduating and being able to repay their debts.

What the Department of Education does now is give direct loans to every college student who demonstrates financial need, but without examining evidence of academic ability and other criteria of credit-worthiness. From the liberal standpoint, this policy provides crucial educational opportunities to young people from low-income families. Liberals are willing to have taxpayers pay for the higher default rate in exchange for increasing educational opportunities for children from low-income families. They ignore the fact that students from low-income families already receive Pell grants as well as other need-based scholarships that do not require evidence of good credit ratings or superior academic performance. The Pell grant program has been an expensive drain on the budget and continues to grow. In the 2009-10 academic year, Congress appropriated $25.3 billion for Pell grants for 7.74 million American students; in 2010-11 Congress appropriated $32.9 billion for 8.87 million American students; and in 2011-12, Congress appropriated $34.5 billion in grants to 9.4 million college students. However, students also need loans because the cap on Pell grants, $5,550 in 2010-2011 for students from the lowest-income families, does not provide enough money for the rising tuition rates at most colleges and universities.

Congress established a loan program in addition to the grant program because it seemed politically untenable to provide grants large enough to cover the expenses of the millions of students who wanted to attend college. The logic of loans was to give students partial responsibility for the cost of their post-secondary educations. However, because the federal government guarantees repayment of the loans, taxpayers are ultimately responsible.

The three possible approaches to the student loan problem are as follows:

1. Turn all the loans into grants so that taxpayers rather than students are responsible for repayment.

2. Continue to provide student loans to all students who demonstrate financial need regardless of whether or not many default.

3. Insert a risk-assessment component into student loans that considers credit-worthiness and past academic performance in order to maximize the likelihood of loan repayment and minimize defaults.

The first proposal is unlikely to attract support, given current concerns with budget deficits and the overhang of the large national debt. Under the second proposal, the trillion dollars of student debt that has already accumulated will grow and the defaults will increase. The third proposal is the only way to keep student debt under control. The best argument against it is that some students who would ultimately pay back their loans will not receive them because they don’t appear to be good risks to the screeners and, conversely, that some students who look like good risks to the screeners will ultimately default. Of course, in a decentralized system of loan allocation, students denied a loan from one bank might receive it from another. Although mistakes will be made, the question is whether a student loan system that attempts to control the risk of default is better than one that gives loans promiscuously to all college applicants? Voters would probably say that it is. Moreover, attempting to control the risk of student defaults has an important advantage, as I argued at length in the final chapter of my book, The Lowering of Higher Education in America: dangling the prospect of obtaining needed student loans before students and their parents will create an incentive for college students and would-be college students to behave more responsibly. They will be more likely to pay attention in class and do assigned reading, less likely to spend weekends drunk or on “recreational” drugs, and less inclined to accumulate a bad credit rating by maxing out their limits on several credit cards. In order to work as a continuing incentive, this assessment of academic prospects and other criteria of credit worthiness should be carried out at the end of every academic year. In short, a side effect of the risk-assessment approach to student loans is to nudge students in the direction of making responsible adult behavior more attractive — even respectable.